Streetwise Professor

December 22, 2013

SIPs as Public Goods: Underinvestment in Linkages in Securities Markets

Filed under: Derivatives,Economics,Exchanges,Regulation — The Professor @ 7:30 pm

A few days ago the WSJ reported that US securities exchanges are close to upgrading one of the Securities Information Processors, the part of the RegNMS market structure that links the various exchanges.  The SIP consolidates and disseminates quote data from the various exchanges.  It provides the linkages that are necessary for the links-and-information structure created by RegNMS.

The SIPs have been a source of chronic complaints in the industry.  The current fix was compelled by a breakdown in the SIP over the summer that caused a shutdown in trading of some stocks.  But even when the SIPs work, they disseminate information more slowly than the private connections between exchanges and HFT firms.  This gives an advantage to HFT traders.

The WSJ story indicates that the operating system of the SIP is obsolete.

This issue illustrates an inherent problem with a utility-type model in securities markets. I discussed this problem in my research in the late-90s and early-00s, including in a JLEO article that was published in 2002.  That research was focused on a CLOB model, but the same issue is relevant for a the current SLOB (Simulacrum of a Limit Order Book) model. Specifically, a utility CLOB (or SLOB) has strong public good aspects.  All market participants benefit from better technology and improved performance, but would prefer that others pay for it.  Collective action and public goods problems tend to lead to under provision of quality and technological improvement.

SIPs are industry public goods, and face the same problems.  No wonder they are obsolescent.

There are other problems with the linkages approach that undermine incentives to  invest in SIP quality and technology.  The whole idea behind the linkages approach is to facilitate competition between exchanges.  But exchanges have no incentive to facilitate competition between themselves.  Competition is likely to be weaker with a kludgy linkage system, so why should exchanges push to improve it?  Not to mention that some interests, notably HFT, which would face a diminished competitive position with  more advanced SIP, also have an incentive to impede updates.

This is an inherent challenge to the linkages approach.  Its effectiveness depends on, well, the technology that links markets.  But the incentives to invest in those linkages are suboptimal due to the public good problems, exacerbated by the fact that competing exchanges don’t have an incentive to intensify competition between them.

But as I’ve often written, the alternatives have their own problems.  Most notably, if you don’t mandate linkages between markets, order flow network effects tend to cause the dominance of a single exchange.   So you need linkages and socialization of order flow if you want competition, but there will be underinvestment in the linkages.

US securities markets are committed to the linkages approach.  Public goods problems that provide inefficiently weak incentives to invest in the links necessary to make the approach work mean that it will be beset by chronic difficulties.

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  1. Fear not, Professor:

    Elizabeth Warren (Fauxcahontis) & Ed MaHkey are on the case! The worthy successors to Barney Frank & Chris Dodd.


    PS What’s THAT you say? They were the ones who created the problem? But but but… Vlad thought that was ‘fixed.’

    Comment by Vlad — December 22, 2013 @ 10:49 pm

  2. @Vlad. That’s exactly what scares me. I always refer to the junior senator as Ed Malarky. Fits perfectly. And Warren is definitely on the warpath. Who are you to doubt her Native American warrior roots?

    The ProfessorComment by The Professor — December 22, 2013 @ 11:17 pm

  3. The only way to level the playing field is have clearing inside each exchange, with one CLOB for each stock. The one that gets the liquidity wins. I never understood why they continue to have +3 clearing on the stock side.

    Comment by Jeff — December 27, 2013 @ 6:36 am

  4. @Jeff. That is the alternative to the linkages approach. But as I’ve written repeatedly the inevitable result is a single exchange for a particular instrument, which exercises market power. It’s a pick-your-poison situation. More competition with the problems associated with linkages that can break, especially during times of stress, vs. more robust monopoly exchanges that exercise market power. The choice is a rather stark one. I tend to lean towards your choice. What irks me is that few in the debate acknowledge that the choice is what it is.

    The ProfessorComment by The Professor — December 27, 2013 @ 1:51 pm

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